Answer by Suyash Chandak:
Consider two countries X and Y. Let price of an apple (the only product in the economies) be 10 and 100 (in their domestic currencies) in their respective domestic markets.
If the exchange rate of between the two currencies is 1:1, that is 1 unit of currency x costs a unit of currency y. In this situation cost of an apple in Y is 10 times to that in X.
Thus it will be favourable for Y to import apples from X. For this they will have to sell y to buy x which they will in turn use to buy apples. This will splurge the currency y in the market and devalue it till the exchange rate is 1:10. Why? At this exchange rate the apple will cost the same in both the countries.
The general relative price level in two different economies more than anything else determines the exchange rates.
- Net Exports/Imports. Countries with higher trade surplus tend to have higher exchange rates.
- Government Policies. China is continuously dumping Yuan in the international market to keep it devalued which would encourage its exports.
- Speculation also has an impact but its impact is limited to short run fluctuations.
Hope this helps. I have refrained from getting into technical details to keep it simple. Feel free to ask me anything in the comments?